Money supply versus money demand

According to popular thinking, not every increase in the supply of money will have an effect on the production of goods. For instance, if an increase in supply is matched by a corresponding increase in the demand for money, then there won’t be any effect on the economy. The effect from the increase in the supply of money is neutralized, so to speak, by the effect of an increase in the demand for money or the willingness to hold a greater amount of money than before.

What do we mean by demand for money? And how does this demand differ from demand for goods and services?

Now, demand for a good is not demand for a particular good as such but rather demand for the services that the good offers. For instance, individuals’ demand for food is on account of the fact that food provides the necessary elements that sustain an individual’s life and well-being. Demand here means that people want to consume the food in order to secure the necessary elements that sustain life and well-being.

Likewise, demand for money arises on account of the services that money provides. However, instead of consuming money, people demand money in order to exchange it for goods and services. With the help of money, various goods become more marketable – they can secure more goods than in the barter economy. What enables this is the fact that money is the most marketable commodity.

Take for instance a baker, John, who produces ten loaves of bread per day and consumes two loaves. The eight loaves he exchanges for various goods such as fruit and vegetables. Observe that John’s ability to secure fruits and vegetables is on account of the fact that he has produced the means to pay for them. The baker pays for fruit and vegetables with the bread he has produced. Also note that the aim of his production of bread, apart of having some of it for himself, is to acquire other consumer goods. Now, an increase in John’s production of bread, let us say from ten loaves a day to twenty, enables him to acquire a greater quantity and a greater variety of goods than before. As a result of the increase in the production of bread, John’s purchasing power has increased.

In the world of barter, John may have difficulties securing the various goods he wants by means of bread alone. It may happen that a vegetable farmer may not want to exchange his vegetables for bread. To overcome this problem, John would have to exchange his bread first for some other commodity, which has much wider acceptance than bread. In short, John is now going to exchange his bread for the acceptable commodity, and then use that commodity to exchange for goods he really wants.

Note that by exchanging his bread for a more acceptable commodity John in fact raises his demand for this commodity. Also, note that John’s demand for the acceptable commodity is not to hold it as such but to exchange it for the goods he wants. Again, the reason why he demands the acceptable commodity is because he knows that with the help of this commodity he can convert his production of bread more easily into the goods he wants.

Now let us say that an increase in the production of the acceptable commodity has taken place. As a result of a greater amount of the acceptable commodity relative to the quantities of other goods, the unitary price of the acceptable commodity in terms of goods has fallen. All this, however, has nothing to do with the production of goods. The increase in the supply of acceptable commodity is not going to disrupt the production of goods and services. Obviously, if the purchasing power of the commodity were to continue declining, then people are likely to replace it with some other more stable commodity.

Through a process of selection people have settled on gold as the most accepted commodity in exchange. In short, gold has become money.

Let us now assume that some individual’s demand for money has risen. One way to accommodate this demand is for banks to find willing lenders of money. With the help of the mediation of banks, willing lenders can transfer their gold money to borrowers. Obviously such a transaction is not harmful to anyone.

Another way to accommodate the demand is that instead of finding willing lenders, the bank can create fictitious money – money un-backed by gold – and lend it out.

Note that the increase in the supply is given to certain individuals. There must always be a first recipient of the bank’s newly-created money.

This money, which was created out of “thin air”, is going to be employed in an exchange for goods and services. It will set in motion an exchange of nothing for something. The exchange of nothing for something amounts to the diversion of real wealth from wealth-generating to non-wealth-generating activities, which masquerades as economic prosperity. In the process, genuine wealth generators are left with fewer resources at their disposal, which in turn weakens the wealth generators’ ability to grow the economy.

Could a corresponding increase in the demand for money prevent the damage that money out of “thin air” inflicts on wealth generators?

Let us say that on account of an increase in the production of goods the demand for money increases to the same extent as the supply of money out of “thin air”. Recall that people demand money in order to exchange it for goods. Hence, at some point, the holders of money out of “thin air” will exchange their money for goods. Once this happens, an exchange of nothing for something emerges, which undermines wealth generators.

We can thus conclude that irrespective of whether the total demand for money is rising, what matters is that individuals employ money in their transactions. As we have seen, once money out of ‘thin air’ is introduced into the process of exchange, this weakens wealth generators, and this in turn undermines potential economic growth. Clearly, then, the expansion of money out of “thin air” is always bad news for the economy. Hence, the view that an increase in money out of “thin air” is harmless when fully backed by demand doesn’t hold water.